Manufacturing the market we want

30/03/2013 § 3 Comments

A lot of economic theory is about markets. We then add government in as something that moves the market away from equilibrium. Subsidies, taxes, quotas, regulations, etc. — these are all ways in which government moves the market away from our assumption of what have happened otherwise. We never observe the counterfactual. We end up working backward from what we observe to what we think might have been.

And then we get situations like the affair with Rio Tinto/Meridian/Mighty River. The basic story is:

  • the Government is trying to sell part of Mighty River as the first of its State Owned Enterprises sell-offs
  • the sagging market for aluminium and high New Zealand dollar has led Rio Tinto to put pressure on Meridian to sweeten the deal around electricity prices
  • Meridian doesn’t want to give the shop away, and is resisting Rio Tinto’s negotiating tactics
  • the Government is concerned that lack of a deal will drop electricity prices, which would affect the market value of Mighty River shares.

I think I’ve got the story right, although I might not, so please feel free to set me straight in the comments.

The core problem for an economic analysis is that there isn’t really a market operating. The Government intervenes on the supply side of the electricity market through the SOEs. The Rio Tinto smelter as well as all the country’s households and other businesses make up the demand side. Now, the Government wants to step into the demand side to prop up demand from the smelter, rather than letting the two companies negotiate an agreement.

The intervention will be artificially inflating electricity demand above the level expected, given world prices and the exchange rate. This extra demand will boost consumer prices (and will cause more use of coal- and gas-fired plants, leading to more GHG emissions). That is, consumers will be paying a hidden transfer to Rio Tinto via power prices.

On the other hand, inflated demand will allow the Government to receive higher prices for the Mighty River share float, and then also for the planned Meridian float. That’s good for taxpayers and the public finances, but it’s bad for investors (and electricity consumers). Of course, an individual might be a taxpayer, investor and consumer all at once — are they better off?

The other worrying thing is that the Government intervention looks very much like ‘channel stuffing’. This is a business practice of artificially (and temporarily) increasing the sales figures in order to make the business look better than it really is. In this case (follow the bouncing ball), the Government would borrow money to raise Meridian’s sales figures to inflate the value of Mighty River to raise the value of the share float to pay off the borrowing.

This doesn’t require a market analysis; it needs a Rube Goldberg diagram.


The big dry

12/03/2013 § 6 Comments

We’re in a drought. Pastures are drying out, stock are stressed, and Wellington now has water restrictions (very mild water restrictions, it must be said).

The costs are being toted up. The figures being tossed around are in the $1 to $2 billion range (0.5% to 1.0% of GDP, roughly), which compares to agriculture being ~10% of GDP. If it hits lambing or breeding stock, the impacts could go on past this season. Given the weak economic recovery, there are concerns about moving back into recession.

The drought is, of course, a lack of water. But really, it’s a lack of insurance. By insurance, I mean information and infrastructure that protect us from downside risk. There isn’t enough of that around water in New Zealand, and no wonder. We haven’t needed it. But this year we do, and climate change is expected to increase the variability of weather and make ‘insurance’ more important.

Just for example…

You may remember that December was wet, so the hydro dams were spilling water over the Christmas break. If not, the great memory machine can help out. Lake Ohau, Lake Pukaki, Aviemore, Waitaki, Benmore, Tekapo, Roxburgh — all were spilling water. My wife — South Island born and bred — said that was a bad sign, that they’d be telling us to conserve power in the autumn as a result. Well, it’s not quite at that level, but it’s getting there.

One thing clearly missing was better information. The current drought is unusual:

The February rainfall into Lake Te Anau in the South Island was the lowest since records began 80 years ago, Meridian Energy said yesterday….

Going from full at the start of January to the 1992 level in March had never happened before, [Leyland] said.

The past wasn’t going to be a good guide to the future. If we can figure out better models of weather, precipitation, power generation, power usage, etc., then we can have better control over the lake levels. That’s going to cost money to figure out, but it’s like buying an insurance policy.

Another kind of insurance is increased storage. The country as a whole is not short of water. It is just in inconvenient places at inconvenient times. Storage and distribution can overcome those problems — it’s like money in the bank or an insurance policy against drought. As or if the variability of rainfall increase(s), the value of that insurance policy also increases.

There’s also the consumption side. Because we aren’t used to extended dry periods, we aren’t that efficient with water.We could be, though, and that’s something else we should figure out. Unfortunately, the consumption needs to be supply-sensitive. That is, we should reduce our consumption in dry years but correspondingly increase it in wet years when we can. That kind of flexibility will have a cost to it, just like buying insurance.

And, it really, really suggests we need some kind of rationing mechanism for water, so that people are using more or less of it depending on how much is around. Prices are economists’ first choice for rationing, because they allow people to make individual decisions about how much that water is worth to them.

We aren’t the only people to face uncertainty around water. We’re lucky — we tend to have lots of it. We just need to work out how to manage the variability. Other places — Australia, California, Israel — have to make do with less. That means we don’t even need to be particularly clever; we just need to learn from them. Think of it as importing insurance.

Water erodes asset sales

18/07/2012 § 3 Comments

I feel a bit sorry for National. They made asset sales a central issue in the last election, they won, and now they want to go ahead with their plans. It was all clear and above board. See where that got them.

On the other hand, the Maori Party, Winston Peters, and assorted other people and organisations have a point. How can you sell hydropower companies if you haven’t first worked out who owns the water?

At first, the question seems daft. The State Owned Enterprises have reservoirs and dams, these are used to generate power, and the power produces a revenue stream. The Government wants to sell shares in the company, that is, shares in the future potential net revenues. They aren’t selling water; they are selling company shares.

A little more reflection, and the Maori objection to selling the companies because of the water is very clever. The SOEs might own dams and turbines and whatnot, but they are of no value if they can’t use the water. That’s a spanner in the Government’s plan to sell SOE shares.

The Government could tell prospective buyers that existing water practices will be recognised and grandfathered and everything will tick along as before. But that course means that the national discussions over water policies have been superseded by the asset sales: some existing water rights are been assured, while others will be contested. Alternatively, the Government could sell the shares while acknowledging that there’s a bit of uncertainty over water. That puts the future revenue at risk, which means the shares will sell at a discount.

The issue about water rights, by the way, is this. Well-specified water rights include the amount, quality, timing, and location of the water. Now imagine that a farmer has rights to extract a certain amount of water from a river in January. A power company might need to hold that water in its dam until January to meet that obligation. Let’s say water levels are a bit low in December. The company has a choice: let the water turn the turbines in December, or release the water in January for the farmer. Is it going to look after its revenues, or after the farmer’s water rights?

So the various Maori organisations have put National in a bind:

  • it sells the shares, with a pledge to protect the SOEs’ water allocations, undermining the water talks (including with the rural base)
  • it sells the shares, but takes a discount because it doesn’t pledge to protect the allocations; the asset sales generate less revenue than expected, vindicating the opposition
  • it holds off selling the shares until the water issue is sorted, halting one of its second term’s signature intiatives and handing its political opponents a victory.

Of course, the sale doesn’t have to be all or nothing. The Government could have a partial partial asset sale, only selling those shares that aren’t at risk from the water controversy. That’s a halfway measure that won’t appease anyone.

Which means it’s probably perfect politics.

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